Low yields spell big challenges for investors

The super-low interest rate environment and its effect on long-term bond yields will intensify the retirement savings challenge for investors and may overturn traditional asset allocation models, according to a new report.

The new report, published by CIBC World Markets, examines the plight of Canadian investors and portfolio managers in the current low-rate rate environment, given that, “one asset class, federal government bonds, has essentially disappeared as a way to make money.”

The report said that high-grade sovereign bonds are essentially equivalent to cash these days, as they are “likely to offer nothing much in return in the coming decade, and like cash, [are] valued mainly for safety and liquidity.”

The report estimated that a market-weighted portfolio of Government of Canada bonds (2s, 5s, 10s, and 30s) will produce a compound annual return of just 0.6% over the next 10 years.

“If, as we expect, inflation averages close to 2% over that horizon, that’s a negative real return for a full decade,” the report said.

This view is echoed in a new report from Mackenzie Investments, which said, “We believe that low yields are the new paradigm for long-term investors, rather than a cyclical bump in the road. The current crisis has simply sped up the ongoing shift towards a ‘lower for longer’ yield environment.”

For investors and portfolio managers, the reality of low yields means adding risk to meet long-run return expectations, or increasing savings to offset weaker returns.

“A lower risk-free rate implies that long-term savers require more assets to fund a target level of retirement income as accumulated savings compound at a slower growth rate,” the Mackenzie report explained.

For instance, when long-term yields average 3%, an investors needs to save about $1.8 million to finance $100,000 in annual spending for 25 years. At 1% long-term bond yields, that rises to $2.2 million; and, “If rates decline further to zero, required assets at retirement increase to $2.5 million.”

Faced with higher pre-retirement savings needs, many investors may instead look to take on more risk to fund retirement through higher returns.

“While higher expected returns reduce required savings at retirement, higher risk portfolios also have a greater ‘risk of ruin’ should valuations drop sharply after retirement,” the Mackenzie report warned. “This could leave retirees with insufficient assets to fund their spending needs.”

Moreover, CIBC said that government bonds likely don’t have much upside potential — undermining their traditional role as a source of diversification.

“If equities were to reverse their recent run up, there simply isn’t a whole lot of room for bond prices to rally as an offset, except perhaps at the very long end of the curve,” the CIBC report said.

As a result, investors may then have to turn to other alternatives to balance their equity allocations.

“Alternative investment strategies with absolute return objectives and low correlation to traditional stock market returns as well as outcome-oriented asset allocation strategies with downside protection using options could play a useful role,” Mackenzie said.

James Langton

James is a senior reporter for Advisor.ca and its sister publication, Investment Executive. He has been reporting on regulation, securities law, industry news and more since 1994.